Glass-Steagall Is Necessary, but the Argument for It Isn’t

I’ve made the argument before, so there’s no reason to repeat it at length here. The reality is that reinstating the Glass-Steagall Act has about as much chance of happening as the financial industry walking away from its $300 million a year in lobbying.

You think bankers are whining about higher capital requirements? Glass-Steagall would be the biggest threat yet to their industry, compensation and way of life. It just isn’t going to happen.

Nevertheless, a bipartisan group of lawmakers led by Sens. Elizabeth Warren, (D., Mass.) and John McCain, (R., Ariz.), last week introduced legislation that would bring back Glass-Steagall, the Depression-era law that separated retail and commercial banking from investment banking.

The effort to revive Glass-Steagall is noble, but political reality is much different today than when the law was passed in 1933.

Back then, for example, the stock market crash of 1929 was fresh in the nation’s consciousness. Banks were closing at a terrifying pace, and savers lost $400 million in deposits, or $7.1 billion in inflation-adjusted terms, because of the failures. There were no food stamps.

Sen. Elizabeth Warren (D., Mass.)

Getty Images

Massive unemployment, shattered savings and other calamities added up to political pressure that was too big to ignore.

In addition, the banking and securities businesses back then weren’t as complicated as they are today.

But two things were happening. Banks packaged bad loans and sold them to investors. (Does that sound familiar?) And banks provided margin loans to investors for their portfolios. In other words, deposit-taking institutions also financed stock trading.

So when the so-called Pecora commission set out to investigate what happened and what to do about it, lawmakers had two things going for them: a simple problem and the political support to make sweeping changes.

It was pretty clear that separating the lending and securities industries would have the desired effect.

Glass-Steagall was pretty much a slam dunk even though the first version was passed by the Senate in a lame duck session in 1932. The add-on creation of the Federal Deposit Insurance Corp. was highly controversial.

But the tide was swelling. The panel’s 10 days of hearings on National City Bank led to the resignation of Charles Mitchell, the bank’s chairman.

Imagine that. A banker resigning after being embarrassed publicly. In May, the Banking Act of 1933 passed by a 262-19 vote in the House. The Senate approved a similar bill by voice vote.

Our most recent financial crisis was a bit more complicated and circumstances now are far different.

These days, the stock market flirts with new highs almost every day. The sting of the financial crisis and 2009 lows have ebbed. Unemployment has ebbed: it was 7.6% in May, compared with 23.6% in 1932.

Bank failures after the financial crisis didn’t compare to the massive failures of the Depression Era. A total of 486 banks have failed since the start of 2008, according to the FDIC. And while it’s true there are fewer banks and more megabanks today, many of those bigger banks were bailed out. The point: The severity of the most recent crisis was masked by government assistance.

For depositors at those banks that failed, there was the FDIC. And for Americans battered by unemployment, there are food stamps.

Perhaps the biggest change today is that opponents of reinstating Glass-Steagall claim that banking is too complicated and too global for such a simple solution. They also argue that Glass-Steagall wouldn’t have prevented the financial crisis.

A key part of that argument was that banks were already participating in the securities business when Glass-Steagall was effectively repealed by the Gramm-Leach-Bliley Act in 1999.

That’s true. But it’s not the whole story. In the late 1980s, banks successfully argued that they should have limited participation in the securities markets. These divisions were called “Section 20s,” referring to a loophole built into the original law.

Section 20s were a crack in the wall. The 1999 law knocked it down. In essence, the 2000s became a free-for-all mix of loans, securities and derivatives.

So you can see the dilemma. The modern demise of Glass-Steagall is in part why that law can’t be resurrected. The tangle of “financial innovation” spurred by the repeal 14 years ago gave banks plausible deniability when confronted with the same allegations Pecora asked of Mr. Mitchell.

What’s more, the bailouts shielded banks and the public to the consequences of their own mistakes.

Taken together, it’s a compelling narrative of why Glass-Steagall is such a necessary law. And why it isn’t going to make a comeback.